Downside Variance Premium, Firm Fundamentals, and Expected Corporate Bond Returns

41 Pages Posted: 9 Jul 2020 Last revised: 13 Jul 2020

See all articles by Tao Huang

Tao Huang

Beijing Normal University-Hong Kong Baptist University United International College

Liang Jiang

Fudan University - Fanhai International School of Finance (FISF)

Junye Li

Fudan University - Department of Finance

Date Written: June 16, 2020

Abstract

We find a positive relationship between individual downside variance premia, the difference between risk-neutral and physical expected downside variances, and future corporate bond returns. The hedge portfolio earns the economically substantial and statistically significant excess return of 0.35% (0.39%) per month in value (equal)-weighted returns. The predictive power of downside variance premium is stronger in non-investment-grade (long-maturity) corporate bonds than in investment-grade (short-maturity) ones. We show that downside variance premium positively relates to the likelihood of future default and cash flow uncertainty and negatively relates to future cash flow. When rational investors anticipate a high likelihood of future default, high cash flow uncertainty, or low future cash flow, the current bond price has to decline, resulting in higher future bond returns.

Keywords: Downside variance Premium, Corporate Bond Return Predictability, Equity Options, Probability of Default, Credit Rating Downgrade, Cash Flow Uncertainty

JEL Classification: G10, G12, G14

Suggested Citation

Huang, Tao and Jiang, Liang and Li, Junye, Downside Variance Premium, Firm Fundamentals, and Expected Corporate Bond Returns (June 16, 2020). Available at SSRN: https://ssrn.com/abstract=3628444 or http://dx.doi.org/10.2139/ssrn.3628444

Tao Huang

Beijing Normal University-Hong Kong Baptist University United International College ( email )

2000 Jintong Road
Zhuhai, Guangdong 519087
China

Liang Jiang

Fudan University - Fanhai International School of Finance (FISF) ( email )

220 Handan Road
Shanghai, 200433
China

Junye Li (Contact Author)

Fudan University - Department of Finance ( email )

Shanghai, 200433
China

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